8% ROI Good for prime location?

Question

I'm new here and I figured I'd see what everyone has to say about an 8% return on a retail/office building in a prime downtown area.

3200 of the 6000 sqft are currently rented out, 1500ft is rented for $2300/month, 500 for $550/month, and first floor 1000sqft is rented for $3100/month. That leaves 2800sqft sqft unrented on first floor. (expecting to rent for $8000/month)

I made an offer that the owner seems to like for $600k cash now, then an additional $1M cash after we get the unrented space rented with a good tenant for going rates.

That means net around $47000/yr if space goes unrented with 600k invested OR $141000/year with 1.6M invested.

I'm horribly afraid of missing something with this much money on the line. The building seems to be well taken care of, have to check the roof still, no buried oil tanks,.....what else am I missing?

Bill Gulley · Answer

Without knowing what the market is, you are paying a premium from the norm of 10% cap to rents. I too like the stepped offer, but, you're leaving out the time value of money for the lease up term. In other words what's the value of that additional lease 6 months later or a year? How marketable is it? I agree that 147K is more like 1.47 M, 47K at 470K, not sure I;d dump 1M based on a new tenant, depends on the tenant and the value of that lease. There are stistical measures for the valuation of a lease, you'll need extensive research as to the market and you can ask a good MAI appraiser may do that in your area. I would probably discount future rents at 18% until lease up and 12% over the remaining term as a simplistic approach. Your discount has much to do with the potential of landing a strong tenant, I'd guess you're looking at decent tenants for that amount of space, taking it all, but you may need to break it down to smaller spaces, higher rents but also small tenants are usually not as strong, so it's at a higher risk too. At this level, I suggest you employ the services of your CPA and attorney before making a binding offer and since you came in high, IMO, I'd blame them as the excuse saying my CPA aand attorney just said no....hmmm? The 600k down is fine, but that has about 150k being paid up front for an unrented space, so consider that as well in assessing the present value of the future lease. Not sure what Dion was saying but a smaller space rents at a higher per ft amount than a larger one. Rents usually go down as space goes up, it's the location of being on the ground floor for walk in/off street and having to go up elevators, or worse, steps. There can be exceptions, such as "penthouse" space with unusual amenities, skyline views, but I don't think this has such aspects. 5 cents worth :)

Dion DePaoli · Answer

8% in today's market is prime, and is the value put on Class A assets, with a little downward pressure in larger MSA's. The question here, is this property worth 8% or should you earn more? 47% of the property is currently vacant I like your step offer for the vacant space. IMO, you are putting a very high premium on the empty space further increasing the value of the property without cause. There was no mention as to the Tenant Improvement needs to rent that space nor if the leases are single, double or triple net. You are estimating that the vacant space will lease out for $2.86 psf and therefore the weighted average of all your space rents at $2.37 psf. Yet the actual weighted average of the property is $1.93. So buried in your valuation, you have the empty space adding value instead of detracting value. A premium of 22%, mind you. You do deal with this in some manner with your step offer but it is unclear what happens in the event the step fails and what it takes for the step to fail such as lesser lease amount or space consumption, etc. The current occupied space you are at 10.80% gross yield. Yet for the vacant space lease target is at 9.60%, one whole point less. So essentially, you drove the price up or are evaluating too high, in my opinion, I would have pushed down, being a little more conservative with future events. It is unclear what type of tenants the three that are currently in the building are from the post (short term/long term). However, the leases are worlds apart. One tenant is at $0.91, $1.53 and $3.10. The smaller the unit, the smaller the premium. Is this a function of the building or local market? None the less, a situation I would look into. When i crunch the numbers in general I show you with less than 8.0% return. That said, with the above variables and story gaps, IMO I think you are paying too much for this asset. I think your valuation on the vacant space is where you can get yourself into trouble. I am guessing this is a tertiary market. As such I think real prime needs to be no less than 8.0% cap but I think this asset currently looks more like a 10%. You are giving some very aggressive stabilized values, which seem unwarranted from the post, in my opinion. I am around $200k less on the offer than you and that still might go even further down based on the vacant space potential cash flow and filling in some of the gaps. Curious what others think.

Rob Ward · Answer

Thanks for the response, I also forgot to mention the unrented space is due to owner moving out of it. He wants to stay but can't afford going rates. We're in the process of negotiating him staying in the space until his space is filled and negotiating his rent. I was thinking perhaps giving him free rent, but to cover his expenses AND get him to take $100k of the price. There's probably an equation that will tell us how much to take off the asking price for every dollar in rent he pays until his space is filled for going rates. Any other leveraging ideas?

Bill Gulley · Answer

Welcome to BP Rob! Doesn't sound like you're that new, I assume you have a business background. Is 8% sufficient, absolutely it is or can be depending on your situation. Look to your opportunity costs, the alternative investments you may have. How you leverage the deal will impact your return. Prime locations carry a higher price, which translates to lower ROI usually, you should consider appreciation in prime locations, that's where most of your long term returns might lie. Inspect the snot out of it! That's where it can hit you. Check tenants and financials, business history and management abilities, thier success is your success. Look to the value of the opportunity to own that location, it can be a hard assessment or a gut feeling, I assume it's an investment for you, not a job. Good luck :)